Understanding Basis

1. Understanding Basis • Definition • Influence factors • Basics of basis • Patterns and trends

2. Basis Basis = Cash – Futures • Futures reflect global S&D • Basis reflects the local S&D Cash = Futures + Basis

3. Basis basics • Specific to time and place • Typically use nearby futures • Convergence • Less variable than cash • Relatively predictable

4. Basis Factors • Relative storage capacity • Transportation availability and cost • Time to expiration • Quality issues

5. Iowa Grain Price Reporthttp://www.ams.usda.gov/mnreports/nw_gr110.txt

6. Iowa Grain Price Reporthttp://www.ams.usda.gov/mnreports/nw_gr110.txt

11. Specific to time and place http://www.ams.usda.gov/mnreports/lsddgr.pdf http://www.card.iastate.edu/ag_risk_tools/basis_maps/ www.BeefBasis.com http://www.econ.iastate.edu/faculty/lawrence/Acrobat/CurrentLiveCattleBasis.pdf http://www.econ.iastate.edu/faculty/lawrence/Acrobat/CurrentHogBasis.pdf

12. Grain Basis vs. Livestock Basis • Grain is a storable commodity and the same grain can be used to satisfy several futures contract delivery months. So grain futures prices tend to be tied to one another. • Livestock is not storable so livestock futures prices for alternative delivery months tend to move independently. • Because grain is a storable commodity, the grain basis is tied closely to grain storage costs and interest costs. Livestock are not storable so there are no storage costs built into the basis.

13. Grain Basis vs. Livestock Basis • An inverse basis in grain futures (cash above futures) is unusual and indicates there is something amiss in the grain industry (lack of transportation, for example). An inverse basis in grains will usually last only for a short period. • An inverse basis in livestock futures is not unusual for distant delivery contracts and can exist for extended periods of time. Only during the nearby futures contract delivery periods do we expect livestock futures to be above cash price.

14. Basis Summary • Difference between cash and futures • Reflects local conditions • More predictable than futures • Essential to effective hedging

15. Introduction to Hedging • Definition • Types • Mechanics

16. Hedging definition • Hedging is buying or selling futures contracts as protection against the risk of loss due to changing prices in the cash markets. • Holding equal and opposite positions in the cash and futures markets • The substitution of a futures contract for a later cash-market transaction

17. Market participants • Hedgers are willing to make or take physical delivery because they are producers or users of commodity. • Use futures to protect against a price movement • Cash and futures prices are highly correlated • Hold counterbalancing positions in the two markets to manage the risk of price movement

18. Short Hedgers • Producers with a commodity to sell in the cash market at some point in the future • Are hurt by a price decline • Short hedgers • Sell the futures contract initially • Buy the futures contract (offset) when they sell the physical commodity

19. Long Hedgers • Processors or feeders that plan to buy a commodity in the future • Are hurt by a price increase • Long hedgers • Buy the futures initially • Sell the futures contract (offset) when they buy the physical commodity

20. Preharvest short hedge example • A farmer will have 50,000 bushels of corn to sell after harvest • The farmer is long the cash market • Damaged by a price decline

21. The Storage Hedge • Store grain at harvest for sale a later date • Protect against adverse price change • Help earn a carrying charge • Storage, interest

22. The Storage Hedge Time Cash July Fut Basis Nov 1 $3.40 $3.85 $0.45 Action store sell July 1 $3.70 $3.00 $0.30 Action sell buy Gain/loss +$0.30 -$0.15 +$0.15 Net gain from storage hedge is +$0.15 and is equal to the change in basis

23. Short hedge for middleman • It is March. A grain elevator has storage available and is thinking about buying corn to store until July. • Estimated storage cost is $0.10/bu • Current spot (cash) price is $3.40/bu • July corn futures are at $3.70 • Expected July basis is -$.15/bu

24. Short hedge for middleman • Compare expected price to current price • Expected July hedge price • $3.70-.15-.01= $3.54 • Less storage cost -.10 • Net price in July $3.44 • Current spot price $3.40 • Profit potential per bushel $.04 • What is the risk?

25. Short hedge for middleman • What if prices rise by July? • $4.20-.15-.01= $4.04 • Less storage cost -.10 • Net price in July $3.94 • Current spot price $3.40 • Cash profit per bushel $.54 • Futures G/L (3.70-4.20) -.50 • Net profit $.04

26. Short hedge for middleman • What if prices fall by July? • $3.20-.15-.01= $3.04 • Less storage cost -.10 • Net price in July $2.94 • Current spot price $3.40 • Cash profit per bushel -$.46 • Futures G/L (3.70-3.20) +.50 • Net profit $.04

27. Short hedge for middleman • What if the basis changes from expected? • $3.20-.25-.01= $2.94 • Less storage cost -.10 • Net price in July $2.84 • Current spot price $3.40 • Cash profit per bushel -$.56 • Futures G/L (3.70-3.20) +.50 • Net profit -$.06 • Basis changed $.10 and net profit changed $.10

28. Hedging Summary • “Counterbalancing investment” “equal and opposite” position in cash and futures • Used to manage price risk • Basis estimation is essential • Allows for forward contracting